Converting a Traditional IRA[1] to a Roth IRA merely recharacterizes the nature of the IRA with some added benefits and potential drawbacks.  With current income tax rates relatively low, now may be a good time to make the conversion, but there are a few items to consider before doing so.

Traditional IRAs are tax deductible on the front end of contributions, meaning that an individual under age 50[2] can contribute up to $6,000 to a Traditional IRA in 2019 (increased from $5,500 in 2018 under the Tax Cuts and Jobs Act), which is then deductible from one’s federal income taxes.  Once the individual reaches retirement age and begins taking from the IRA, he or she is taxed on the income they receive from the IRA.  Since the Traditional IRA funds have been accumulating interest or capital gains since their contribution date, the individual is burdened paying tax on both the principal and interest in the account at a potentially higher rate than if paid earlier.

In contrast, Roth IRAs frontload the taxes paid so that an individual cannot take a deduction for contributions made in the year they were made.  Rather, he or she counts the income contributed as income received during the year for income tax purposes.  Thereafter, when the individual retires, the income held in the Roth IRA is tax-free as it is distributed.  Thus, any interest which has accrued on the Roth IRA since the contribution date is similarly tax free.

Only individuals with an annual income under $135,000 (or $203,000 for married individuals filing jointly) are eligible to contribute to a Roth IRA.  Until recently, if an individual was ineligible for a Roth IRA, they were also ineligible to convert their traditional IRAs to Roth IRAs.  The IRS amended its prior rulings to remove the income cap on conversion to make it a workaround for individuals otherwise ineligible to have Roth IRAs.  The process creates a “back-door Roth IRA.”  Now those making over $135,000 can convert their Traditional IRAs to Roth IRAs in this way.  Individuals who initially started contributing to Traditional IRAs are also eligible to convert, regardless of their annual income.

To convert a Traditional IRA to a Roth IRA, an individual just needs to inform the financial institution holding the IRA that he or she would like to transfer.  There are a few ways to do so.  First, the individual can take the funds directly from the Traditional IRA to deposit elsewhere.  The individual then needs to deposit the funds into a Roth IRA account within 60 days to avoid a 10% early distribution tax penalty.  If not, the funds are taxed as ordinary income in the year withdrawn and are subject to the 10% penalty.  In addition, the individual’s tax bracket may preclude conversion after the 60-day window is passed since he or she would regain ineligibility for a Roth IRA.

Second, the individual could conduct a trustee-to-trustee transfer where the trustee for the Traditional IRA is directed to send the funds to a Roth IRA account at a different financial institution.  This option removes the possibility of forgetting the 60-day window to avoid the 10% penalty on early withdrawal but complicates the process.  The financial institution holding the Traditional IRA account will still need to account for the 10% early withdrawal penalty but can release it once the Roth IRA is established.

Lastly, the individual could simply set up a Roth IRA with the same financial institution that holds the Traditional IRA and direct the trustee on the Traditional IRA to roll the funds over into a Roth IRA account.  The funds stay within the same financial institution, and the individual is guaranteed to avoid the 10% penalty.  For all three options, the conversion must be reported on a Form 8606 when taxes are filed for the year the conversion took place.

Before choosing to convert a Traditional IRA account to a Roth IRA, it is important to consider that the contributor is responsible for income tax payments on the Traditional IRA funds being converted.  Any funds converted to a Roth IRA must be taxed so an individual cannot benefit from sheltering all retirement funds by converting them.  The funds are reported and taxed as ordinary income, so individuals opting to convert their Traditional IRAs should be mindful of how much they choose to convert.  Since the Traditional IRA account transfer amount is grouped with an individual’s ordinary income, the process of conversion may boost the individual into a higher tax bracket, depending how much the contributor had in the Traditional IRA or chooses to convert.

A way to offset this “realized income” might be to pair the taxable Roth IRA conversion with a substantial or equivalent charitable gift (like a gift to a Donor Advised Fund or a Charitable Lead or Remainder Trust).  The deduction from the contribution(s) could then be used to offset the income “earned” from the IRA conversion.  Individuals choosing any type of retirement savings should discuss with a professional the tax consequences on both the front and back ends of the investment, and individuals choosing to make this type of conversion will need to consider the tax implications for the year in which the conversion is completed.

[1] IRA: Commonly referred to as an Individual Retirement Account, but actually defined to mean an Individual Retirement Arrangement.

[2] Note that the threshold may be higher for those who own their own businesses.

This article was written with contribution from Sarah Rothermel, 3rd year law student at Widener Law Commonwealth.